Roth IRAs and 401(k)s offer the potential to build tax-free growth into your portfolio. (UBS)

There is a limit on how much you can contribute to Roth accounts each year (see our Savings waterfall worksheet for details), but there is no limit on the amount of tax-deferred assets that you can convert to Roth each year. A reliance on tax-deferred assets could create a “tax time bomb” for your retirement years, when you will be taxed on distributions from those accounts. Roth conversions can help you to reduce your income tax burden in retirement by adding tax-exempt dollars to your balance sheet.

As with Roth contributions, you will need to pay income taxes on any Roth conversions. A full Roth conversion in a single year would be ill-advised, generating a lot of taxable income that could be taxed at a higher tax rate. Instead, we generally recommend implementing partial Roth conversions—converting a small amount each year—in order to smooth taxable income out across as many years as possible. This approach can help you move taxable income from higher tax brackets to lower tax brackets, and help reduce your lifetime tax burden.

Four reasons to consider a partial Roth conversion

#1) Markets are down. Completing a partial Roth conversion when your account value has fallen allows you to get a “discount” on the tax cost of the conversion. The tax savings would be even greater if your retirement accounts include non-deductible contributions; because your non-deductible contributions have already been taxed, you will only have to pay taxes on any growth that they’ve generated—not on the contributions themselves.

#2) Your taxable income may be higher in the future.

What will your taxable income look like in the future? If your estimated future tax rate will be higher than your tax rate in the current year, then completing partial Roth conversions this year may help you save on taxes. If your tax rate will be lower in the future, then keeping assets in a Traditional retirement account, and continuing to contribute to Traditional IRA and 401(k) accounts, may outweigh the benefits of Roth contributions or conversions. However, it’s important to remember that Traditional retirement accounts will add to your taxable income in retirement when you tap them for spending. The more you contribute to Traditional retirement accounts, and the more that you grow these assets, the greater your taxable income in retirement will be. Over-investing in Traditional IRA and 401(k) assets today may actually increase your overall tax burden and could reduce your after-tax wealth in retirement.

#3) Taxes will probably go higher. According to the US Debt Clock, the US government currently has about USD 30 trillion in outstanding debt, and another USD 170 trillion in “unfunded liabilities” in the form of Social Security, Medicare, and other benefits. It’s certainly possible that entitlement reform and spending cuts will be part of the government’s solution to this debt burden, but it’s also highly likely that higher taxes—especially on higher-income Americans—will be a major part of the solution. If the bulk of your wealth is saved in tax-deferred retirement accounts, higher tax rates are likely to have an impact on your after-tax wealth.

#4) Roth conversions can enhance your tax diversification. “Tax diversification” helps you to decide how much taxable income and investment income you will have in a given year, allowing you to manage your tax burden more dynamically throughout retirement and reducing the risk that future increases to tax rates will chip into the value of your retirement assets by spreading your wealth across multiple account types:

  • Tax-deferred accounts (Traditional IRAs and 401(k)s),
  • Tax-exempt accounts (Health Savings Accounts, Roth IRAs and 401(k)s, etc.), and
  • Taxable accounts

How to tell if you should consider a partial Roth conversion this year

The most important consideration is your tax rate today, and how it compares to the tax rate you will face in future years. If you will be in a higher tax rate at some point in the future, you may want to consider a partial Roth conversion (and, if you are in your working years, you may want to allocate a portion of your retirement savings into a Roth account).

There are three possible scenarios:

Scenario 1: Your future tax rate will be lower than what it is today. It may not be worthwhile to implement a Roth conversion this year, because you will have an opportunity to implement a Roth conversion or take a taxable distribution at a lower tax rate in a future tax year.

Scenario 2: Your future tax rate will be the same as it is today. You should talk with your financial advisor and your tax advisor about a partial Roth conversion. A Roth conversion this year may not save you directly on expected taxes, but it could still help you improve your tax diversification, protect your retirement accounts against potential tax increases in the future, and help you to take advantage of the market decline, adding to your portfolio's future tax-free growth.

Scenario 3: Your future tax rate will be higher than it is today. A partial Roth conversion this year could help you to reduce the tax cost of your retirement savings, especially if taxes go higher in the future. You should talk with your financial advisor and your tax advisor about a partial Roth conversion.

Conclusion and next steps

In order to implement a Roth conversion for the 2022 tax year, you will need to take action by year-end—and you should probably start the process as soon as possible to make sure you have time to fully consider your options and beat the year-end rush.

There are many considerations that we don’t account for in this rule-of-thumb analysis. For example, you may have other income; tax rates might change; you might move to a state with a higher or lower income tax during retirement; and your investments' growth and income might push you into a higher tax bracket. There are also non-tax consequences that you should also take into consideration. For example, a higher taxable income might result in higher Medicare premiums. Therefore, it is important to discuss this decision with your financial advisor and tax advisor, incorporating all the specifics of your family's financial circumstances and objectives.

Main contributors: Ainsley Carbone, Jeff LeForge, Daniel J. Scansaroli, Justin Waring, Katie Williams

Content is a product of the Chief Investment Office (CIO).

Original report - Last chance: You should consider a partial Roth conversion this year, 11 November, 2022.

Important note: Tax strategies can be complex. In addition to federal taxes imposed on ordinary income and capital gains, there may be state and local taxes that must be considered.